Monday, 22 September 2008

Newtonian gamble

It is 1947. The Cold War is starting. A group of defence strategists get together to figure out how to best tackle it. They start with the analysis of the world war finished only two years earlier. They focus on details, where, of course, the devil lives. Weapons, or in general ‘military technology’ is all based on Newtonian mechanics. That is, the weapons that count. Or rather, the weapons that have counted so far. The world war was fought and won with arms from the pre-Einstein age. The two nuclear bombs, used at the very end, did not have much military effect. 

How large a mistake that would have been. To form the defence strategy of the 1950’s ignoring the reality of weapons based on quantum mechanics.

This is the recurring thought I have had reading the end-of-week press digesting last week’s ‘turbulent events’. Certainly, some regulatory armoury proposed in-line with the old thinking might still be appropriate. (Just as Newtonian mechanics does not contradict relativity theory, but is merely a sub-case -- and anyway you can use it to efficiently calculate the trajectory of the defence rockets that are to take down the incoming nuclear warhead-carrying missiles.) Most other ‘Newtonian ideas’ miss the point. For instance, it makes no sense to call for the regulation of executive pay. Do the politicians and their economic advisors (surprisingly from both ends of the political spectrum) really think that the current global meltdown is due to the contract structures of CEO’s? Even if they did encourage a risk-taking attitude?

At the start of last week, it looked as if the coming days were to bring the worst that could come, but would also lead to an entirely new world: the rise and definition of a global-economy-management institutional framework. It has happened to some extent. The US treasury secretary (who overnight has become the fiscal policy opinion leader of the world) is calling for semi-harmonised global treasury action, but with operations staying strictly on the national level. However, the big opportunity to change the intellectual framework and to look ahead has been largely missed. 

Apart from some calls for new thinking in the tsunami of analyses, there is not much that is filtering through. The particular actions, although they look brave (or brash), are products of the old framework. And, mostly, they are attacked or supported with the narrative of the past. 

Furthermore, the actions focus solely on the problems that have surfaced so far. The benevolent observer could argue that by saving the US financial system, global financial contagion can be stopped. Even if it comes at an exorbitant cost to be paid in the future in terms of cash, as well as the mess the uncertainty about ‘rules’ will make. If the world financial system is saved, the argument may go, the real economy impact will be small, while global contagion will be halted. 

People with a more diabolical approach to life would suggest that the wished-for buffering of sectoral and global contagion relies even more on containing the collapse in appetite for risk than on a direct cash injection. The sigh released by the markets at the end of last week is based on the axiom that the government, in particular the US government, is a risk-free institution. But isn’t what happened that the systemic risk coming from the potential collapse of several large actors in the economy has been reduced by shifting the risk onto the level of the entire system? Making the assumption that the system - the framework in which the individual actors operate - is unquestionably stable is an intellectual cheat.

Just as the Cold War turned out to be about perceptions of the two sides’ nuclear abilities, it seems that the perceptions of the global economic framework might turn out to be as important as the national-level regulatory weaponry. It is time to move beyond the era of Newtonian regulations if we are ever to reach the global economics theory of relativity.


  1. Isn't it irresponsibly risky to start using a new framework? Or at least, could be perceived as such, and hence would undermine the effort?

    It seems that predictable old rules might be part of the answer because they are predictable and old. Or at least, risk-averse policy-makers might be inclined to think so. Stepping out of the current thinking and framework is a gamble in itself.

  2. Good point. You are right. Using the old framework of thinking is safer in terms of being fairly sure of what to expect as the immediate reaction of the economy to your policy actions. Furthermore, coming out with something completely new, would probably be regarded as wacky, and would ultimately unnerve the already screaming markets.

    The difference between ‘wacky’ and ‘new direction for all’ is leadership. A real leader looks ahead, anticipates what no one else does, and acts reassuringly in accordance with the problems that are coming towards her. In the current context, this would mean that you’d have to move beyond mending the bit of the system that has been obviously broken already, namely the US financial system, to finding solutions that will be broken pretty soon. That is the rest of the world’s financial system, the non-financial part of the global economy (which will get the next blow, and that could be much worse than this one), and some specific countries that could sink spectacularly (quite a few emerging economies would fall in this category) causing even more damage to the world economy.

    I don’t think that there has been anybody fitting that bill of ‘leadership’. The obvious person, the US president -- where is he? Bernanke? Has he given a new vision? The new guy on the global block, Paulson? Only old framework. How about McCain and Obama? Global vision? Nowhere in sight. The non-US leaders? ECB? Germany? France? UK? Japan? Anybody?

    It seems to me that leadership in terms of sharing a vision, and showing a new, credible direction is missing entirely.

  3. Interesting as always... just to lighten the mood, here's a 60 year old black woman's take on capital as a malignant organism whose movements no rules or regulations have the power to contain:

  4. of course there is no new ideas, but thats more the rule than the exception. most policy makers can never escape the framework of their own times.

    and what sort of times are we in ?
    one of moral hazard and an unwilingness to tolerate pain. so while the market should act as a stabiliser, rewarding good choices and punishing bad, the last 15 years everything has been done to alleviate pain when it occured, in the belief that when a company fails, then something 'must be wrong' and something has to be done.

    so policy makers intervene to alleviate the pain short term, but imposing larger and larger long term costs.

    this is still the current framework, policy makers are busily trying to get rid of the symptoms of a flawed system.

    unfortunately they nurtured a beast which can not be tamed, and its all getting out of control now

  5. A similar observation about the absence of leadership in a NYT leader today.

  6. A retrospective, Enron time failure of leadership piece.

  7. tamas, you ask for new thinking. i don't know if thinking in general is the strength of the 'global decision makers'. have you seen the text of the bailout deal?

    it promises some immediate relief of expectations, but only if you believe in it...

    other than that: more uncertainty, and piles of hidden costs -- this is no bail-out, neither buy-in. this is merely a bail-in (which, incidentally rhymes with an other mentally challenged us politician...)

  8. And it got rejected. But, unfortunately, it seems that throwing it back has more to do with short term political calculations than actual arguments. Populism is rampant on both sides. I bet Paulson and co. are dead tired trying to push something (anything) through. (And there is nothing more promising than sleep-deprived decision making...)

  9. Have you seen this? Also about leadership...